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Chapter # 3
Risk Management
Hypothecation agreements:
A broker will allow an investor to borrow money in order to purchase
securities with those securities as collateral. The investor owns the
securities, but the broker may take them if the debt is not serviced or if the
value of the securities falls below a certain level

We have two types of Buying and Selling Securities:

• Cash: the buyer gives to the seller the value in cash and receives the
stocks.
It means the buyer pays to the seller and receives the stock
within 5 days.

• Margin account: the investor open hypothecation account at the

broker firm.
Hypothecation account: it is an agreement between an investor
and broker. According to this agreement the investor borrows
cash or securities from the broker.

We have two types of Margin Account:

1) Margin Purchase

The investor covers part or percentage of the transaction by his or her

equity. This percentage is known as initial margin.

• Initial margin (IM): the percentage of the transaction financed by the

investor.IM determines by the central bank and can be increased by
the Capital Market Authority but cannot decrease it.
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Risk Management
When do we use margin purchase?

Margin purchase is used when an investor expects that the price of

underlined stock will increase in the near future.

Example 3-2:

On March 10th, Reem purchased on margin 1000 shares of United stocks

at $30, the initial margin is 60%.

Prepare Reem balance sheet as in March 10th.

In this case AM = IM
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Risk Management
If the price increases to $45 she will make gain $15, but if the price decline
less than $30 she will make losses.at this time if Reem disappeared the
broker take all the losses.

• Maintenance Margin (MM): is the minimum actual margin of the

account. When the price decrease to maintenance margin the broker
issues margin call to the investor. When the investor receives the
margin call he must do one of the following :
1. Provide collateral assets to increase the equity in the
account.
2. Close the account paying the loan.
Maintenance Margin: is the minimum actual margin of the account

𝐸𝑞𝑢𝑖𝑡𝑦
• Actual Margin (AM) =
𝑚𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑠ℎ𝑎𝑟𝑒𝑠

The actual margin in the beginning = initial margin

Example 3-3:

On April 10th, the price of United stocks increased to $45.

• Prepare Reem balance sheet on April 10th.

• What is the type of the accounts?
• Compute share ROE on April 10th
Suppose interest rate 10% annualy
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Risk Management

When AM > IM this is an over margin account

In this case the investor has the right to sell part of stocks or
withdraw cash till the AM = IM
To find ROE:
𝑁𝑒𝑡 𝑃𝑟𝑜𝑓𝑖𝑡
✓ ROE=
𝐸𝑞𝑢𝑖𝑡𝑦
✓ Net profit= selling price – initial price – (initial price ×( 1-IM) × IR
× time)
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Risk Management
Example 3-4:
On Jan 5th,Ali issued a margin purchased order to his broker for 5000
shares of Gulf stocks at $40. On May 2nd the price of Gulf stocks declined
to $35.The initial margin is 70% and maintenance margin is 50%
• Prepare Ali balance sheets on April 5th and May 2nd.
• What is the type of the accounts?
• Compute share ROE on May 2nd if IR 10%
Note:

✓ Loan is never affected by

changing in price.
✓ Assets and Equity are
affected.

When AM > MM

AM < IM

The account is restricted

In this case the investor can’t ask the broker for his or her stocks or withdraw cash from
the account
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Risk Management
Example 3-5:

On Jan 2nd,Sahar issued a margin purchased order to his broker for 2000
shares of National stocks at $25. On Augast 2nd the price of National stocks
declined to $18.The initial margin is 65% and maintenance margin is 45%
• Prepare Sahar balance sheets on Augast 2nd.
• Compute the actual Margin
• What is the type of the account?
• Compute share ROE if IR 9%
First Balance Sheet

Sahar Balance Sheet

Jan 2nd
Asset Liability and Equity
2000 shares of National stocks 50,000 Loan 17,500
IP× 𝒏𝒐. 𝑺𝒂𝒉𝒂𝒓𝒆𝒔
IP× 𝑛𝑜. 𝑆𝑎ℎ𝑎𝑟𝑒𝑠 × (1 − 𝐼𝑀)
25× 𝟐𝟎𝟎𝟎
25× 2000 × (1 − 65%)

Equity 32,500
Total-Loan
50,000 - 17,500

Total Asset 50,000 Total Liability and Equity 50,000

𝐸𝑞𝑢𝑖𝑡𝑦 32,500
Actual Margin (AM) = = = 0.65 = 65%=IM
𝑚𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑠ℎ𝑎𝑟𝑒𝑠 50,000

Second Balance Sheet

Sahar Balance Sheet
August 2nd

Asset Liability and Equity

5000 shares of Gulf stocks 36,000 Loan 17,500
EP× 𝒏𝒐. 𝑺𝒂𝒉𝒂𝒓𝒆𝒔
18× 𝟐𝟎𝟎𝟎 Equity 18,500
36,000-17,500
Total Asset 36,000 Total Liability and Equity 36,000
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𝐸𝑞𝑢𝑖𝑡𝑦 18,500
Actual Margin (AM) = = = 0.5133 = 51.33%
𝑚𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑠ℎ𝑎𝑟𝑒𝑠 36,000

type of the account

MM < AM < IM
45% < 51.33% < 65% The account is restricted
Share ROE if IR 9%
𝑁𝑒𝑡 𝑃𝑟𝑜𝑓𝑖𝑡 𝑁𝑒𝑡 𝑝𝑟𝑜𝑓𝑖𝑡 −7.45
✓ ROE= = = = −0.305 = −30.5%
𝐸𝑞𝑢𝑖𝑡𝑦 𝐼𝑃×𝐼𝑀 25×65%
✓ Net profit= EP – IP – (IP ×( 1-IM) × IR × time) =
7
= 18 – 25 – (25 ×( 1-65%) × 9% × )= -7.45
12
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Risk Management
Example 3-6:
On Jan 5th, Noha issued a margin purchased order to his broker for 1000
shares of Gulf stocks at $40. On May 2nd the price of Gulf stocks declined
to $18.The initial margin is 70% and maintenance margin is 50%
• Prepare Noha balance sheets on May 2nd.
• What is the type of the accounts?
• First Balance Sheet

Noha Balance Sheet

Jan 5th
Asset Liability and Equity
1000 shares of National stocks 40,000 Loan 12,000
IP× 𝒏𝒐. 𝑺𝒂𝒉𝒂𝒓𝒆𝒔
IP× 𝑛𝑜. 𝑆𝑎ℎ𝑎𝑟𝑒𝑠 × (1 − 𝐼𝑀)
40× 𝟏𝟎𝟎𝟎
40× 1000 × (1 − 70%)

Equity 28,000
Total-Loan
40,000 - 12,000

Total Asset 40,000 Total Liability and Equity 40,000

𝐸𝑞𝑢𝑖𝑡𝑦 28,000
• Actual Margin (AM) = = = 0.70 = 70%=IM
𝑚𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑠ℎ𝑎𝑟𝑒𝑠 40,000
• Second Balance Sheet

Noha Balance Sheet

May 2nd

Asset Liability and Equity

1000 shares of Gulf stocks 18,000 Loan 12,000
EP× 𝒏𝒐. 𝑺𝒂𝒉𝒂𝒓𝒆𝒔
18× 𝟏𝟎𝟎𝟎 Equity 6,000
18,000-12,000
Total Asset 18,000 Total Liability and Equity 18,000
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𝐸𝑞𝑢𝑖𝑡𝑦 6,000
Actual Margin (AM) = = = 0.3333 = 33.33%%
𝑚𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑠ℎ𝑎𝑟𝑒𝑠 18,000

type of the account

AM < MM
33.33% < 50% The account is call margin account

When AM ≤ MM

The account is call margin account

In this situation the broker issue margin call to the investor and the
investor must do one of the following actions:

1. Close the account.

2. Increase the equity to the level that AM=IM

If the investor doesn’t react the broker immediately goes to the market and
sells the stock to cover the loan.
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Risk Management
Example 3-7:

On January 15th, Wael purchased 5,000 shares of National Cement Co. on margin for

$150 per share. On March 15th the price of National Cement stock declined to $100.The

initial margin and maintenance margin requirements were 60% and 40% respectively.

• Prepare Wael balance sheets as in January 15th and March 15th.

• What is the type of the accounts on March 5th?

• Compute share ROE on March 15th if IR 10%

First Balance Sheet

Wael Balance Sheet

Jan 15th
Asset Liability and Equity
5000 shares of National Cement 750,000 Loan 300,000
stocks IP× 𝑛𝑜. 𝑆𝑎ℎ𝑎𝑟𝑒𝑠 × (1 − 𝐼𝑀)
IP× 𝒏𝒐. 𝑺𝒂𝒉𝒂𝒓𝒆𝒔 150× 5000 × (1 − 60%)
150× 𝟓𝟎𝟎𝟎
Equity 450,000
Total-Loan
750,000 - 300,000

Total Asset 750,000 Total Liability and Equity 750,000

𝐸𝑞𝑢𝑖𝑡𝑦 450,000
Actual Margin (AM) = = = 0.60 = 60%=IM
𝑚𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑠ℎ𝑎𝑟𝑒𝑠 750,000

Second Balance Sheet

Wael Balance Sheet
March 15th

Asset Liability and Equity

5000 shares of Gulf stocks 500,000 Loan 300,000
EP× 𝒏𝒐. 𝑺𝒂𝒉𝒂𝒓𝒆𝒔
100× 𝟓𝟎𝟎𝟎 Equity 200,000
500,000-300,000
Total Asset 500,000 Total Liability and Equity 500,000
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𝐸𝑞𝑢𝑖𝑡𝑦 200,000
Actual Margin (AM) = = = 0.40 = 40%
𝑚𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑠ℎ𝑎𝑟𝑒𝑠 500,000

type of the account

AM = MM

40% = 40% The account is call margin account

Share ROE if IR 10%

𝑁𝑒𝑡 𝑃𝑟𝑜𝑓𝑖𝑡 𝑁𝑒𝑡 𝑝𝑟𝑜𝑓𝑖𝑡 −51 −51
✓ ROE= = = = = −0.5666 = −56.66%
𝐸𝑞𝑢𝑖𝑡𝑦 𝐼𝑃×𝐼𝑀 150×60% 90
✓ Net profit= EP – IP – (IP ×( 1-IM) × IR × time) =
2
= 100 − 150 − ( 150 × (1 − 60%) × 10% × ) = −51
12

=
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2) Short sale

Short sale: the sale of share not owned by the investor but borrowed
through a broker and later purchased to replace the loan.

For example: if stocks are sold now for $50 and there is an expectation that
after 2 months it will decline to $35. The investor goes to the broker and
asks to borrow stocks. The investor sell stock for $50 and when the stock
reaches $35 he buys it again to give back to the broker.

The difference in the price is the gain. The broker also takes commission on
each share.

Example 3-8:

On Nov7th, Bandar issued short sale order to his broker for 1000shares of
International Food Co. Stock at $100. On Feb5th, the stock price decreased
to $80. The initial margin is 50%.

1. What are the balance sheets as in Nov7th and Feb5th?

2. Compute the ROE on Feb5th if the interest rate 10%.

The loan will be changed if the price

changes

✓ If the market price increase the

loan increase
✓ If the market price decrease the
loan decrease
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First Balance Sheet

Bandar Balance Sheet

Nov 7th
Asset Liability and Equity
Cash 100,000 Loan 100,000
1000 shares International food company
1000*100

IM 50,000 Equity 50,000

150000-100000
Total Asset 150,000 Total Liability and Equity 150,000
𝐸𝑞𝑢𝑖𝑡𝑦 50,000
Actual Margin (AM) = = = 50% = 𝐼𝑀Second Balance Sheet
𝐿𝑜𝑎𝑛 100,000

Second Balance Sheet

Wael Bandar Balance Sheet
Feb 5th

Asset Liability and Equity

Cash 100,000 Loan 80,000
1000 shares International food company
1000*80

IM 50,000 Equity 70,000

150000-80000
Total Asset 150,000 Total Liability and Equity 150,000
𝐸𝑞𝑢𝑖𝑡𝑦 70,000
Actual Margin (AM) = = = 87.5%
𝐿𝑜𝑎𝑛 80,000

AM>IM

87.5%>50% OVER MARGIN

Net Profit 21.25 21.25

ROE= = = = 0.425 = 42.5%
IM∗intial price 100×50% 50
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Net profit= IP – EP + (IP ×IM ×IR × time) =
3
= 100 − 80 + (100 × 50% × 10% × ) = 21.25
12
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Formulas

1) Margin Purchase

𝐸𝑞𝑢𝑖𝑡𝑦
Actual Margin (AM) =
𝑚𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑠ℎ𝑎𝑟𝑒𝑠

Loan = Initial price ×(1-IM%)

Equity = market value of asset – loan

Net Profit
ROE=
Equity

Net profit= ending price – initial price – (initial price ×(1-IM) × IR

× time)

Equity= IM× initial price

2) Short sale

𝐸𝑞𝑢𝑖𝑡𝑦
Actual Margin (AM) =
𝐿𝑜𝑎𝑛

Loan = price of stock × number of shares

Net Profit
ROE=
IM∗intial price

Net profit= initial price – ending price + (initial price ×IM ×IR ×
time)